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StrictlY Confi4ential
MEMBER BANKS COLLATERAL NOTES
SECURED BY GOVERNMENT WAR OBLIGATIONS.
The Act approved September
7 1916
1
1
amended Section 13
of the Federal Reserve Act by adding thereto the following
paragraph:
"Any Federal Reserve Bank may make advances to its member
banks on their promissory notes for a period not exceeding fifteen days at rates to be established by such Federal Reserve
Bank1 subject to the
revie~
and determination of the Federal
Reserve Board1 provided such promissory notes are secured by
such notes 1 drafts1 bills of exchange or bankers' acceptances
as are eligible for rediscount or for purchase by Federal reserve banks under the provisions of this Act or by .the deposit
or pledge of bonds or notes of the United States."
This particular amendment was suggested to the Banking
and Currency Committees of the House and Senate by the Federal
Reserve Board in the Spring of 1916, at a time when little use
had been made of the rediscount
f~cilities
of the Federal ae-
serve Banks .. · Experience had shown that quite a number of the
larger member banks could use funds to advantage for a few
days at a time and would be willing to secure a.ccommodatior:s
from the Federal Reserve Banks for short periods, while ·they
would have no occasion to use the funds for thirty, sixty or
ninety day periods, and the banks as a rule were reluctant to
offer for discount paper the maturity of .which ran longer than
the time for which funds were needed.
It frequently happened
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652
X-1972
that banks having occasion to use funds for a few days only
would not have available paper of very short n:aturity in sufficient volume to satisfy their requirements and in order that
the Federal Reserve Banks might be in position to respond to
the short time needs of member banks the Board suggested the
foregoing amendment.
Before Congress had taken action, ho.vever, and as the
summer advanced, it became more and more evident that the United
States might be
dra~
into the
~orld
war, and in order to be in
a position to facilitate Government financing in such an event
the Board suggested that
me~ber
banks' fifteen day collateral
notes might be secured also by the deposit or pledge of bonds
or notes of the United States.
Up to May., 1917., member banks 1
collateral notes discounted by Federal Reserve Banks were secured
~lmost
entirely by "notes,
drafts~
bills of exchange or bankers'
acceptances eligible for rediscount or purchase", but since the
issue of the first series of Treasury Certificates of Indebtedness and of the first Liberty Loan., member bankst colh.teral notes
have been secured almost entirely by bonds and notes of the United
States.
It seems, therefore, that it would be proper to d:i.vide member
bankst fifteen day collateral notes into two classes; (1), those
secured by trnotes, drafts., bills of exchange or
bankers~
accept-
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-3ances eligible for rediscount or purchase"., and .(2)., those
secured by "bonds and notes of the United States".
With re-
spect to the first class., it is evident that such notes are
offered by member banks for the purpose of securing short time
accommodations for the exact time the funds are needed.
Uhere
credit is required for a longer time a member bank
en-
~ould
dorse the "notes., drafts., bills of exchange or bankers t accept-·
ances" and rediscount them \:Vith the Federal Reserve Bank.
Trans-
actions of this kind. do not call for any concession in rate
and such notes should properly take the rate established for
rediscounts of longer maturities,
As to class (2)., however, the situation is different.
Member banks have alwa.ys been the purchasers and distributors
of Treasury Certificates and they
~ore
to a very large
exten~
the purchasers and distributors of the various issues of the
Gov·ernment 's war bonds.
Pending distribution it was necessary
for most of the member b,anks., and particularly those 'ffhich
subscribed for liberal amounts., to borrow from the Federal Reserve Banks and the .fifteen day collateral notes secured by
Treasury Certificates, Liberty Bonds and Victory Notes have
always been used as a means of getting the neaded accommodations
from the Federal Reserve Banks.
Paragraph (d) of Section
14
authorizes the Federal Reserve
Banks, subject to the review and determination of the
Federal
Reserve Board to establish rates of discount "for each class of
654
-4paper" and while the banks
ma;r
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classify paper 'according to
maturity or according to the character of security, they
cannot draw a:tJ¥ distinction between notes secured by the
same cl~s of collateral.
Thus a Federal Reserve :Bank mq
establish one rate of discount for member banks t collateral
notes secured by commercial paper eligible for discount end
another rate of discount
of the United States, but
~
notes secured by bonds and notes
it cannot establish two distinct
rates of discount on notes secured by notes and bonds of the
United States.
Therefore while the purpose
of Congress in penni t ting
notes or bonds of the United States to be used as collateral
to merroers banks' fifteen dey notes was to facilitate tbe
war financing of the Govern.ment, no consideration can be
given in establishing discount rates for such paper to the
circumstances attaehed to the ownership of notes and bonds
of the United States by borrowing banks.
It follows, there•
fore, that if a preferential rate of discount should be established for notee of class (2), member banks could avail
thetnSelves of the op-portunity thus afforded of securing
an
commercial accommodations at.the lower rate, andjincentive
would be given to the borrowing of bonds by metriber · banks
and there would be danger of an undue expansion of credit.
:But while a. Federal Reserve Bank carmot establish differential rates on paper of a given maturity having the
.:
'. .
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-5-
same security, it is not prohibited by law from adopting
the policy of receiving certain notes for discount and declining
to consider application for discount of other notes.
There-
'
fore it would seem in the present circumstances that
a Federal Reserve :Bank might properlydivide melriber banks 1
collateral notes into two classes as outlined above, and
discount class (1), that is, notes aecured by eligible commercial
paper, at the current market rates for thirty de.y: paper,
and decline to receive for discount notes of class {2),
that is, notes secured by bonds and notes of the United
States, unless the bonds and notes of the United States are
actually owned by the borrowing bank and are directly connected with the war financing of the Government.
Js Treasury
certificates are being issued to teke care of the floating obligations of the Government arising out of the ','lar, and as the
purchase of these certificates by the banks is an accommodation
to the Government, JI1ember banks•promissory notes secured by such
certificates, having not longer than fifteen days to run, should
be taken freely and there can be no objection to a preferential
rate on paper of this class.
The Board 1s policy has been to ap-
prove the same rate on paper secured by Certificates of Indebt-.
edness as the certificates themselves bear.
This leaves to be considered meniber banks' promissory notes
(
(.
~
656
X- ~972
- 6-
secured by the various issues of Liberty Bonds and Victory Notes.
The Doard has never approved. any preferential rate on mel!lber
banks' collateral notes which were seo.red by bonded obligations
of the United States other than bonds issuei since April, 1917,
but has taken the position consistently that the preferential
!rates given to notes of this class. are for the t:t.econnod.ation
of the
Gove~nt
in its
war
financing.
In sone districts there
are t:lSll7 member banks which for patriotic reasons subscribed
heavily to the Govel'nil'lSnt war bond issues and some of thez:1 have
not liquidated their holdings of such bonds to an extent which
would relieve . them of the necessity of borrowing from the Federal
Reserve Banks on them.
There are cases also where member banks
have liquidated entirely their original subscriptions to Government
..,onrlts
t!:n~
hA-ve repurchased bonds for th'=! se..lte of inves't!!!ent Ett the
lower rates now prevailing il;l the carket, or where member 'banks
have borrowed 'bonds from their customers and have used theo as collateral to fifteen day notes for the purpose of obtaining funds with which
to make comcercial loans.
There does not seem to be any reason why a Federal Reserve Dank
should receive for discount member banks' collateral notes which are
secured by borrowed. bonds or bonds bought purel7 for investment, and
the inquiry is therefore made whether ;your Federal Reserve
B~k
. care to a..1.opt the policy of declining to discount for member
would
(
..
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-1banks their fifteen day collateral notes when secured in this
manner and announce that hereafter it will be its policy to
confine such transactions only to offerings of notes which are
secured by Liberty Bonds and Victory Notes, actually subscribed
for in good faith by the borrowing bank before the allotment
of the final issue of Government vlar bonds, that is1 the
Victory Notes.
The Federal Reserve Banks should also require that all
collateral pledged as security to member banks' fifteen day notes
have a market value at least equal to the face of the note ..
Therefore in discounting member banks' collateral notes secured
by Liberty Bonds and
~ed
Vict~ry
Notes actually subscribed for and
by the member bank, a Federal Reserve Bank should require,
first, that such notes be secured by an amount of such bonds,
the face value of which is equal to the amount of the note, and
second, that the deficiency betNeen the market value of such bonds
and the face of the note be covered by the pledge of additional
notes or bonds of the United States, or by the pledge of notes,
drafts, bills of exchange or bankers acceptances eligible for
discount or purchase by the Federal Reserve Banks.
In consideration of all the attend,3.nt circumstances
and in further consideration of the fact that by the limitations
above outlined,
~t
use of Government
is clear that under this plan there can be no
war
obli~tions
a$
.
'
i
658
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collateral to member bar'ks 1 ftftAen day notes for the purpose- of
securing commercia.l acconmodations at reduced rates, and therefore
n0
addit,ional inflation or expansion of credit, it would be :proper
fur a Federal
Reserv·~
::3ank to bear· in mind the circumstances under
whi.ch the; bonds p:edge d with it are acquired and to make a liberal
cnncess5.on in the discount rate on such paper, that is, on member
'banks' fif·i;een day promissory notes secured by Liberty Bonds and
Victory Notes actually subscribed for and acquired from the Government
'by the borrowing bank, or taken before the final allotment of
Victory Notes, from borrowing subscribers in default.
In tre Board's
opinion, however, it would not be wise to make the rate on paper of
this classification uniform 11\'i th the rz.te borne by the bonds, for
there should be no incentive to the borrowing banks to hold bonds
as a basis of collateral to loans indefinitely.
It has been suggested
that where the notes are secured by Victory Notes which bear
interest that the rate of discount be
by Liberty Bonds bearing
bs· 4-1/2%.
4-·1/4%
5%
4-3/4%
and where notes are secured
interest that the rate of discount
It is fur·J;her suggested that a Federal Reserve Bank, if
it should adopt the foregoing policy and schedule of rates, should
inform its member banks that they will be expected in view of the
favorable rate accorded them to make a reasonable reduction in the
a!OO'Wlt of such notes at the end of each fifteen day period. ~
·member banks could well afford to zr.ake this red.uctibn
to the grnount of interest saved.
e~
at least
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X 1972
It is clearly impracticable to give any preferential rate to
customers' notes which are secured by Liberty Bonds. This would o:pen
up avenues for too large an extension of credit when the large
volume of Liberty BOnds outstanding :is
~onsideret..
A F~deral Reserve
Bank, therefore, should continue to discount for member banks
customers' notes secured by Liberty Bonds and Victory Notes at the
established commercial rate.
Su.ch customers' notes, however, ought
not to be used as collateral to member bariks 1 fifteenday notes of
class (2).
July 3, 1920.
@FedFRASER